The Cost of Capital (Chapter 15). OVU- ADVANCE Managerial Finance D.B. Hamm, rev. Jan 2006. “Cost of Capital?”. When we say a firm has a “cost of capital” of, for example, 12%, we are saying: The firm can only have a positive NPV on a project if return exceeds 12%
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D.B. Hamm, rev. Jan 2006
The Cost of Equity may be derived from the dividend growth model as follows:
P = D / RE – g
Where the price of a security equals its dividend (D) divided by its return on equity (RE) less its rate of growth (g). We can invert the variables to find RE as follows:
RE = D / P + g
But this model has drawbacks when considering that some firms concentrate on growth and do not pay dividends at all, or only irregularly. Growth rates may also be hard to estimate. Also this model doesn’t adjust for market risk.
Therefore many financial managers prefer the security market line/capital asset pricing model (SML or CAPM) for estimating the cost of equity:
RE = Rf + βE x (RM – Rf)
or Return on Equity = Risk free rate + (risk factor x risk premium)
Advantages of SML: Evaluates risk, applicable to firms that don’t pay dividends
Disadvantages of SML: Need to estimate both Beta and risk premium (will usually base on past data, not future projections.)
ABC Corp has 1.4 million shares common valued at $20 per share =$28 million. Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the market. Total market value of both equity + debt thus =$32.65 million. Equity % = .8576 and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18% Tax rate is 40% Current yield on market debt is 11%
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
D.B. Hamm, Jan. 2006
You are now all financial wizards!
End of module!